Problems ahead for China's banks?

Patrick Chovanec is an associate professor at Tsinghua University’s School of Economics and Management in Beijing. Prior to that, he worked for several private equity funds focused on China, and continues to serve as a fund adviser. He's also got a blog. An edited transcript of our conversation about China's economy follows. This is part two of a two-part interview. Part 1 is here.

EK: Let's talk about China's stimulus. A lot of people know that they flooded the market with more than 4 trillion yuan, but you say that's not the half of it.

PC: In November of 2008, when China was first hit by the financial crisis and the began seeing exports drop off, the state council announced the $4 trillion stimulus plan. But there really wasn't so much a plan as an announcement. The way these projects, and much more, were financed was a lending boom that took place throughout 2009. The banks in China lent $10 trillion RMB. The country's total loan portfolio expanded by one-third in the course of one year. That really fueled the the growth you saw in China. And remember, it's a state-owned banking system. So when the word went out, go forth and lend, that's what they did.

But the lending actually became larger than they thought. Originally, they wanted $6 trillion in total lending that year. But they blew past that in a month. Then the regulatory commission raised the cap to $7.5 trillion. Then, by the end of June, they hit that, and they couldn't stop lending because that was keeping the economy going. And that was the real stimulus that took place in China.

EK: Presumably, that led to some deterioration in the creditworthiness of the borrowers, right? Are you expecting Chinese banks to face a bad loan problem?

So many loans were made so quickly that you have to imagine the vetting process went out the window. In the spring of last year, China's banking regulatory commission was saying that banks in China were recording record lows in non-performing loans. Then the regulators said, 'Don't worry, these loans are going to government-sponsored development projects, and those are very safe because they're backed by the government.' This year, the Chinese government is particularly worried about those loans. Because local governments can't borrow directly, they set up special entities and then they guaranteed their debts. Banks saw this as riskless. Now the central government has revoked all the local government guarantees on those loans! And I've heard estimates that these loans accounted for 40 percent of the $10 trillion.

EK: Part of the motivation here, as I understand it, is that the Chinese government is very scared about what will happen if GDP growth falls below 8 percent. As such, they'll do pretty much anything to avoid that sort of slowdown. Do you think those fears are contributing to bad economic decisions?

PC: I don't know how 8 percent got codified. But at some point, it did. it became the marker. Every economy needs to grow to keep up with population growth and keep the economy steady. And someone decided that was 8 percent for China. I remember going on TV in China at the beginning of 2009, and they asked me if they'd be able to hit 8%. And I said sure: All you need to do is give migrant workers a shovel and tell them to dig holes and fill them up. But that doesn't create wealth or position China for future growth. This obsession with future growth, while understandable, is an obsession and distraction from the real issue, which is creating value and making a more productive economy.

EK: I left China pretty respectful of the size of that challenge. Matching existing low-wage labor to foreign investment seems easy compared to upgrading the storehouse of human talent. Can China sustain 8 percent growth as it tries to transition its economy to compete higher on the value chain?

PC: Let me give them credit. I sometimes come across as this great bear on China. I'm not! I think the country has huge potential and has accomplished something incredible. There's no question that China can build stuff. What concerns me is that there are problems. China's success over the past 30 years and the apparent success of the stimulus makes it less likely that China will confront these problems and take the hard steps necessary to tackle them. For instance, the challenges of the future will require a social security network in order to make labor markets more flexible and let people consume rather than save.

I think this was a huge missed opportunity in the crisis. Instead of using loans to prop up exporters, there really needed to be a shakeout in the export sector and they could have taken the money and used it to create an unemployment benefit system where people weren't starving and were free to move their labor to more productive pursuits, that would've been a huge step for China. There's a great desire in the face of the economic crisis to freeze the accomplishments of the last 30 years in place. That's the wrong way to look at it. Economies that are dynamic embrace creative destruction. There's a constant process of renewal. The only thing worse than having a recession is never having a recession. There's no penalty for allocating capital and resources in the wrong direction.

Will Chinese banks be in trouble? Chinese banks had to keep a 16% reserve, about 2 times the world average. Chinese banks are very profitable. They make mostly investment loans not consumer loans. Chinese banks are backed by the Chinese government. Chinese people save as much as 30% their income. They keep most of their money in bank deposits until they have enough for a down payment on a property. Most mortgages in China need at least a 30% down payment. Chinese banks survived the Asian crisis in the late 1990's. The sky has to fall down before anything worse can come up.